What is investing?

Like in any sport, investors have always looked for ways to see how well they measure up — how well they’re performing. But, investing is complicated and it’s hard to ensure apples to apples comparisons when tracking success. Enter performance benchmarks, or indexes. These indexes, arbitrary groupings of securities, provide the yardsticks by which many investors measure themselves. And more recently, investors are increasingly investing in the yardsticks themselves.

What is an index?

When a journalist or commentator on T.V. talks about the markets going up or down, ever stop to think what he’s referring to? More often than not, he’s referring not to the entire stock market’s performance, but a select group of stocks indicative of the larger economy.

That group of stocks is an index and it’s typically arbitrary, chosen to represent a specific sector of the economy, or the economy in general. The S&P 500 and the Dow Jones Industrial Average (DJIA) are two of the best known indexes and are routinely quoted in the news. Indexes aren’t completely static, though — index providers make infrequent decisions to move stocks in and out at specific intervals.

History of indexes

One of the oldest, if not THE grandfather, of all indexes is the well-known Dow Jones Industrial Average. Launched in 1896 and comprised of 30 stocks chosen by editors of the Wall Street Journal (owned previously by the Dow Jones Company), the DJIA is supposed to be representative of the strength of the American economy. The companies chosen to be included in the DJIA are typically very large firms, as the 30 companies represent almost 27% of the value of the entire U.S. stock market.

The Standard and Poor’s 500 is a similar animal – instead of 30 stocks, though, a committee chooses 500 to represent the U.S. market (including a handful of foreign companies).

As investors realized that these benchmarks were particularly useful and the investing universe more diverse, more and more indexes have been created while more firms have gotten into the indexing business. There are literally thousands of indexes now.

How investors use indexes

With thousands of stocks traded in the U.S markets, it’s a challenge to determine exactly how well an investor performs. OK, I gained 10% for the year — but, is that good? Should I have done better?

Indexes put performance into context — providing a useful benchmark for investors to compare themselves against. In fact, mutual fund managers are compensated on whether or not they beat a stock market index. They beat an index and they make the BIG bucks.

There’s more to the index story, though. In the 1980s, Vanguard Investment’s Jack Bogle made passive indexing famous. Instead of trying to beat the market (mainly, a very tough slog), Bogle recommended investors join it by investing in funds that mimic the indexes. In fact, there are trillions of dollars in passively managed mutual funds and exchange traded funds (ETFs) — all tracking the moves of the indices.

Who runs the indexes

Most of the early indexes like the Dow Jones Industrial Average and the S&P 500 were developed using value judgements – if early indexes were designed to be representative of the U.S. economy, it was important to have the right flavor and diversity that mirrors our Main Street. So, typically financial journalists were entrusted with this task (they were publishing, anyway). The Wall Street Journal had the DJIA and BusinessWeek’s previous publisher (it’s now owned by Bloomberg), Standard and Poor’s (owned by McGraw Hill) has published the Standard and Poor’s 500 since the 1920′s.

Because benchmarking is so important (hey, if you control the benchmark, you control performance ratings!) and because so much ETF money (+$1 trillion) is following them, there’s been a gold rush to own the indexes themselves. Indexing firms also make money from licensing out their indexes to investment firms who, in turn, create financial products (like mutual funds) around them. MSCI/Barra is the 800 lb gorilla in this space with anestimated $7 trillion in global assets that track the firms indexes.

How indexing has evolved

Indexing has moved from a journalistic endeavor to a very quantitative process. Instead of just picking big American companies, new indexes are calculated by finely-delineated market capitalization criteria and increasingly, financial metrics (revenues, profits, etc.). In fact, you can pretty much create an index that tracks anything (try the Global X Social Media or the iPath UBS Livestock Index or the C-Tracks ETN Citi Volatility Index Total Return)

While every investment firm may be trying to get an invite to the index party, the gray-haired Dow Jones Industrial Average and S&P 500 still hold their own after all this time and are regularly used as benchmarks by both professional and individual investors.

Stock market indexing started as a tool to help investors judge their performance but has morphed into its own industry. Riding the growth in passive investing, indexes have seen a surge in popularity, spawning lots of new products and innovation. The investment industry – and investors – have taken notice.